Thursday 11 October 2007 06.55 EDT
First published on Thursday 11 October 2007 06.55 EDT

New figures from the Treasury showing a bigger-than-expected budget deficit this year and next could turn out to be a lot worse than feared if the turmoil in financial markets lasts, the Institute for Fiscal Studies said yesterday.

The respected thinktank also criticised Alistair Darling's decision to add £2bn to investment spending in Tuesday's pre-budget report, something it described as an "unfunded spending increase".

IFS director Robert Chote said that Mr Darling's most immediate problem was that the credit crunch and a weaker outlook for wage growth were expected to lose him £4bn in income tax revenue and £3bn in corporation tax revenue next year alone. He said, in all, the fiscal position is due to deteriorate by about £13bn over the next three years, which will again delay the long-awaited time when the current budget balance returns to the black.

"The chancellor then expects this hole largely to disappear of its own accord over the next couple of years, as the financial sector recovers and as economic growth picks up. But the size of the revenue loss and the timing and speed of any recovery are clearly uncertain," Mr Chote said.

He pointed out that the government had run into problems with the public finances after the dotcom bust in 2001. That hit tax receipts from the City hard and the impact was deeper and longer lasting than expected. With the financial sector facing problems again, "the government must be hoping devoutly that history is not about to repeat itself".

Mr Chote would not be drawn on how far the public finances could deteriorate, but he said the government was fast using up leeway to meet its own fiscal rules. He said the rules were too vague and predicted that the increased borrowing could mean that the national debt soon busts its ceiling of 40% of gross domestic product.

By squeezing spending growth over the next three years to 2% in real terms a year, half the pace of recent years, Labour would be meeting the Conservatives' third fiscal rule of raising public spending more slowly than growth in the economy, shrinking the share of spending in national income, Mr Chote said. Having decided on its three-year spending totals in the March budget, the government now decided it needed to raise investment spending by £2bn, and fund it by more borrowing.

"Are we really supposed to believe that the Treasury has suddenly discovered some vital pieces of capital investment that need to be done in 2010/11 that it was unaware of in March? Heaven forbid that shorter-term political considerations may have played a role.

"For a party which loves to lecture its opponents on the wickedness of unfunded tax cuts, this looks suspiciously like an unfunded spending increase."

IFS deputy director Carl Emmerson said the slowdown in spending growth would be "challenging" for government departments to keep to. He warned that spending growth was "considerably slower" than in previous reviews and "might prove incompatible with improving public services and reducing child poverty".

The Conservatives jumped on an IFS calculation that the average family would pay £50 a week extra in tax over the next five years. But the IFS said their figures were an illustration showing that economic growth would add £5,500 to family income over the next five years, of which £2,600 was tax and £2,900 net income.

The government came in for further criticism for a change to the second state pension announced by Mr Darling on Tuesday. This involves putting a cap on the second state pension three years earlier than planned, in 2009, raising about £400m a year from then. Conservative shadow pensions secretary Chris Grayling called it a "new stealth tax on retirement". The Treasury said the move was necessary after the tax changes announced in the last budget. "If we had not done this there would have been an anomalous windfall gain for higher earners from 2009."